The purpose of this paper is to present the concept of "entangled tokens", a novel approach to trading that links traders' outcomes, using mutually blocked assets as collateral. This document outlines the mechanism, benefits, and potential applications of entangled tokens.

Introduction

The world of Decentralized Finance (DeFi) has grown rapidly and captured billions of dollars of liquidity. However, this liquidity is stuck in protocols that underutilize allocated capital. How can we solve the inefficiency problem? The answer is in entangled tokens, a radically innovative approach to link traders’ positions via collateral management, freeing up capital and making DeFi more efficient.  

DeFi is revolutionizing the financial markets with open and permissionless access to services, previously inaccessible to people outside of big investment banks, hedge funds, and insiders. Despite DeFi’s rapid growth, traders still face significant challenges in managing their positions effectively,  leading to suboptimal capital utilization and misallocation of resources.

Today, traders face capital inefficiency since they need to collateralize their position when they open a trade. DeFi protocols are designed such that the collateral swap happens immediately when trading starts, instead of when the positions are closed. This inefficiency not only ties up valuable assets but also limits the potential for higher returns, at lower risk.

We introduce a groundbreaking DeFi protocol called Entangled designed to optimize capital efficiency by managing traders' positions in a novel and innovative manner. Our protocol creates entangled tokens that interlink the traders’ positions by making the outcomes of their trades dependent on each. We manage the collateral of positions at the end of their trades, instead of doing an immediate asset swap at the beginning of trades. 

Our Entangled Protocol:

1. adjusts traders' collateral based on interlinked positions by requiring less capital, in turn making markets more efficient,
2. stabilizes markets with the automatic selling of appreciating assets and the buying of depreciating assets,
3. enables a secure method for backing derivative trades with a mutually blocked state until the derivative contract is settled.

At Entangled, we envision a future where DeFi is not only accessible but also highly efficient, enabling everyone to efficiently utilize capital. We invite you to join us in the journey of making financial markets and DeFi highly efficient and scalable. Also, we provide an outlook for future research involving leveraged entangled tokens, multi-trader entanglement, and entanglement of multiple assets.

Specification

The concept of "entangled tokens" involves traders holding interlinked positions in a way that their outcomes depend on each other. This approach involves using mutually blocked assets (collateral) instead of immediate asset swaps on the spot market. 

Here’s a detailed breakdown of how this concept works:

1. Setting Up Entangled Tokens: Two traders, Alice and Bob, enter into an agreement where they each commit a certain amount of assets for swap. This collateral is blocked or held in a smart contract to ensure both parties fulfill their obligations. Instead of swapping assets, they agree to hold their positions with the assets locked. For example, Alice holds 1 BTC, and Bob holds 70,000 USDC. Both parties can initiate the position closure at any time.
2. Issuing Entangled Tokens: Both traders’ collaterals are mutually blocked, meaning they cannot access their committed assets until the position is closed. By locking BTC, Alice issues the entangled token Long USDC. By locking USDC, Bob issues the entangled token Long BTC.
3. Initiating Position Closure: Either trader can initiate the closure of their position. When this happens, the current market prices of the involved assets (BTC and USDC) are used to determine the outcome. The value of entangled tokens is calculated based on the market price at the time of closure.
4. Settlement Based on Market Prices: If BTC has increased in value relative to USDC, Bob (holding a Long BTC token) is considered the winner. Alice is considered a loser and receives a smaller amount of BTC as a result. The winner receives full collateral back plus a profit equivalent to the difference in value, which is deducted from the loser’s collateral
5. Profit Conversion and Market Stabilization: The profit of the winner denominated in the asset that has increased in value (e.g. BTC) is immediately converted to the winner’s original asset (e.g. Bob’s profit in BTC converted to USDC at the spot market price). This automatic conversion helps stabilize the market because it inherently involves selling the appreciating asset (which can help cool down a rapidly rising market) and buying the depreciating asset (which can help support a falling market).

Example Scenario

Let’s consider a practical example to illustrate this concept:

• Alice holds BTC, and Bob holds USDC.
• They block collateral equivalent to the current market value of their holdings.
• Suppose the current price of BTC is $70,000.

Initial market values:

• Alice’s BTC: 1 unit * $70,000 = $70,000
• Bob’s USDC: 70,000 units * $1 = $70,000

Entangled tokens are issued:

• Alice: 70,000 Long USDC (or 1 “Short BTC”) worth of $70,000
• Bob: 1 Long BTC (or 70,000 “Short USDC”) worth of $70,000

Both traders block $70,000 worth of collateral. After some time, the prices change:

• BTC increases to $77000.

Updated market values of entangled tokens:

• Bob’s 1 Long BTC: $77,000
• Alice’s 70,000 USDC: $70,000

Bob is now the winner with an increased asset value of $77,000, while Alice’s asset value has decreased relative to BTC. When the position is closed:

• Alice gets her 0.9091 BTC having a loss of 0.0909 BTC
• Bob gets a profit of 0.0909 BTC from Alice’s collateral.
• 0.0909 BTC worth $7,000 is sold and converted to USDC at the current market price.

This entangled position ensures that market forces act to stabilize price movements, with winning traders receiving profits in a secure and controlled manner while contributing to overall market stability.

A similar scenario can be applied to the negative price change. 

Use Cases and Applications of Entangled Tokens

Market Stabilization

Entangled tokens can help stabilize markets by inherently involving the automatic selling of appreciating assets and the buying of depreciating assets. This process provides liquidity and can reduce market volatility during both upswings and downswings.

By automatically converting profits into the original assets, the system ensures continuous liquidity. When an asset's price rises, selling a portion of it as part of the entangled token settlement process injects liquidity into the market, potentially tempering price surges. Conversely, buying a depreciating asset can prevent prices from falling further, offering a stabilizing effect.

Automatic Position Closure (Take Profit/Stop Loss Conditions)

Traders can set predefined conditions (Take Profit/Stop Loss) at which their entangled token positions will be automatically closed. This mechanism can be implemented using smart contracts, which monitor market prices and execute closure orders when conditions are met.

Traders can establish limit orders corresponding to their risk profiles. For instance, a trader can set a stop loss at a specific price to minimize potential losses, or a take profit level to secure gains once the asset reaches a predetermined value. This automatic closure ensures disciplined risk management and reduces the emotional aspects of trading decisions.

Derivatives Collateral

Entangled tokens can be used as collateral for derivative instruments. This provides a secure method for backing derivative trades, ensuring that collateral is held in a mutually blocked state until the derivative contract is settled.

The use of entangled tokens as collateral can help mitigate the systemic impact of liquidations in the derivatives market. Traditional derivative liquidations can create feedback loops, amplifying market volatility. Entangled tokens, by providing stable and blocked collateral, can reduce the likelihood of cascading liquidations and stabilize the market during periods of high volatility.

Leveraged Entanglement

Future developments could explore leveraging entangled tokens.

Use case: Stable-coin backed by entangled token

The concept of a stablecoin backed by entangled tokens aims to provide a stablecoin with yield backed by a volatile token used as collateral. This approach seeks to attract investors looking for yield while mitigating the systemic risk of stablecoin de-pegging, especially when collateral involves volatile assets. The stablecoin maintains its peg through entangled positions, which provide a yield to investors and help dampen market volatility.

Investor Engagement

USDC holders are attracted to the stablecoin due to its yield-bearing potential.

Investors open entangled positions using their USDC, engaging in a mutually blocked collateral arrangement.

Setting up Entangled Tokens

The volatile token is pledged as collateral in the entangled token system.

The position is locked with a collateral coefficient of 140% to provide a safety margin against price fluctuations of the volatile asset.

Stablecoin Issuance

The entangled position is used to back the issuance of a stablecoin.

Maintaining Peg: The stablecoin's value is maintained by the over-collateralized entangled position.

Yield Payment

The yield generated from the entangled position is paid out in the volatile token.

Investors receive a continuous return on their USDC investment through the yield paid in the volatile token.

Liquidity concerns

If a user reopens a position, then it creates selling pressure which might be a problem in bearish illiquid markets.

Conclusion

Entangled tokens represent a novel approach to trading that links traders' outcomes, using mutually blocked assets as collateral. This paper outlines the mechanics, benefits, and potential applications of this innovative concept, highlighting its potential to provide a fair and versatile trading mechanism.